Question

Integrative—Risk and valuation Giant Enterprises' stock has a required return of 11.6%. The company, which plans to pay a dividend of $1.63 per share in the coming year, anticipates that its future dividends will increase at an annual rate consistent with that experienced over 2009-2015 period, when the following dividends were paid: :: a. If the risk-free rate is 8%, what is the risk premium on Giant's stock? b. Using the constant-growth model, estimate the value of Giant's stock. (Hint: Round the computed dividend growth rate to the nearest whole percent.) C. Explain what effect, if any, a decrease in the risk premium would have on the value of Giant's stock. a. If the risk-free rate is 8%, the risk premium on Giant's stock is %. (Round to one decimal place.) b. Using the constant-growth model, the value of Giant's stock is $ . (Round to the nearest cent.) c. Explain what effect, if any, a decrease in the risk premium would have on the value of Giant's stock. (Select from the drop-down menus.) A decrease in the risk premium would the required rate of return, which in turn would the price of the stock.

Answer 1

Required return = 11.6%

Risk free rate = 8%

a). So, Risk premium = required return - risk free rate = 11.6-8 = 3.6%

b). Average dividend rate = (Dividend in 2015/dividend in 2009)^(1/6) - 1 = (1.52/1.02)^(1/6) - 1 = 6.9%

So g = 6.87%

D1 = 1.63

Ke = 11.6%

Value of stock = D1/(Ke-g)

So, Value of Giant's stock = 1.63/(0.116-0.069) = $34.49

c). A decrease in risk premium would decrease the required rate of return, which in turn would increase the price of the stock